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We recently interviewed the founder of a “note settlement” company who shared some surprising stories about how deeply banks are willing to discount the face value of HELOCs and other junior liens (and sometimes even first mortgages) in a settlement, especially if the borrower is facing a hardship or is underwater.

(You can get access to this fascinating interview on how one California real estate agent built a thriving business helping homeowners settle their notes for pennies on the dollar as part of the Noteworthy Silver Anniversary series. It’s free to sign up.)

But when we heard that some bankruptcy judges are now classifying these junior liens as unsecured debt in certain situations, the motive of the banks settling these notes makes much more sense. Clearly, they would rather get something for the note, as opposed to having it be wiped out completely.

So, if you’re holding a second mortgage as a investor, maybe you should try a little harder to work with your borrowers if they get into trouble. All of a sudden, doing a loan mod and/or offering a forebearance looks a whole lot more appealing…

Here’s an excerpt from an MSN Money article on this new practice.

The mortgage industry doesn’t like it. But it can do nothing as lawyers in the San Francisco Bay area use a little-known aspect of the bankruptcy law to help debt-riddled clients get rid of their second mortgages and avoid foreclosure.

The San Jose Mercury News tells the story. Writes Pete Carey:

Statistics are hard to come by, but bankruptcy lawyers say the provision has been used effectively on hundreds, if not thousands, of cases in the Bay Area during the past two years.

“It’s a big thing in our valley,” said James “Ike” Shulman, a San Jose bankruptcy lawyer. “But it’s not widely known.”

To stop the practice, the mortgage industry would have to change the law. And that’s unlikely in today’s political climate, Carey says.

How it works

This provision in bankruptcy law is not new. But it wasn’t used much when most owners had plenty of equity in their homes.

It applies only to second mortgages. You must keep paying on your first mortgage if you want to stay in your home after bankruptcy.

But for second mortgages, the rules are different. If you owe more than the home is worth –- and a record 28% of American homeowners are now in this position, Zillow.com reported this week — you can petition the bankruptcy court to declare your second mortgage unsecured debt. In bankruptcy, unsecured creditors typically receive little or nothing.

You can get access to a fascinating interview on how one California real estate agent built a thriving business helping homeowners settle their notes for pennies on the dollar as part of the Noteworthy Silver Anniversary series. It’s free to sign up.)
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